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WKL puy DU What is the Cost of Debt? The cost of debt is the effective interest rate a company pays on its debts. It's the cost of debt, such as bonds and loans, among others. The cost of debt often refers to before-tax cost of debt, which is the company's cost of debt before taking taxes into account. However, the difference in the cost of debt before and after taxes lies in the fact that interest expenses are deductible. KEY TAKEAWAYS The cost of debt is the rate a company pays on its debt, such as bonds and loans. The key difference between the cost of debt and the after-tax cost of debt is the fact that interest expense is tax-deductible. Cost of debt is one part of a company's capital structure, with the other being the cost of equity. Calculating the cost of debt involves finding the average interest paid on all of a company's debts. How the Cost of Debt Works Cost of debt is one part of a company's capital structure, which also includes the cost of equity. Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans, among other types. The cost of debt measure is helpful in understanding the overall rate being paid by a company to use these types of debt financing. The measure can also give investors an idea of the company's risk level compared to others because riskier companies generally have a higher cost of debt The cost of debt is generally lower than cost of equity. Example of Cost of Debt To calculate the cost of debt, a company must determine the total amount of interest it is paying on each of its debts for the year. Then it divides this number by the total of all of its debt. The result is the cost of debt. The cost of debt formula is the effective interest rate multiplied by (1 - fax rate). The For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6% rate. The effective interest rate on its debt is 5.2%. The company's tax rate is 30%. Thus, its cost of debt is 3.64%, or 5.2% (1 - 30%). The company also issued a 10-year bond for $2,000,000 on which it pays 7.00% interest. The interest on the first two loans is $50,000 and $12,000, respectively, and the interest on the bonds equates to $140,000. The total interest for the year is $202,000. The company's cost of debt is 6.31%, with a total debt of $3.2 million Cost of Debt After Taxes The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company's effective tax rate from 1, and multiply the difference by its cost of debt. The company's marginal tax rate is not used, rather, the company's state and the federal tax rate are added together to ascertain its effective tax rate. For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of the 5% is 3%. The after-tax cost of debt is 3%. The rationale behind this calculation is based on the tax savings the company receives from claiming its interest as a business expense. To continue with the above example, imagine the company has issued $100,000 in bonds at a 5% rate. Its annual interest payments are $5,000. It claims this amount as an expense, and this lowers the company's income on paper by $5,000. As the company pays a 40% tax rate, it saves $2,000 in taxes by writing off its interest. As a result, the company only pays $3,000 on its debt. This equates to a 3% interest rate on its debt. It is also import to understand the cost of issuance or "loatation costs" when issuing a bond. If you issue a $20,000,000 bond your issuance costs could be five to ten percent of the face value. Think about spending $2 million to raise $20 million. The "oatation costs" an have a big effect on your cost of capital. General Auto Parts Corporation issued a 2-year bond with a face value of $20 million and a coupon rate of 5.5 percent. The company received $18 million from the sale of bonds (after paying floatation costs) and is required to make principal plus interest payments at the end of the next 2 years. The total cash flows (both inflows and outflows) are summarized as follows: TODAY YEAR 1 YEAR 2 Principal $18 million $0.0 million ($20 million) Interest ($0.99 million) ($0.99 million) Total $18 million ($0.99 million) ($20.99 million) What is the cost of capital to General Auto Parts for the debt issue? We can estimate the before-tax cost of capital from the bond issue by solving for kb (bondholders rate of return) in the following bond valuation equation: Net bond proceeds today = interest paid in year 1/(1+kb)1 + interest paid in year2/(1+kb)2 + principal paid in year 2/(1+kb)2 $18 million= $990,000/(1+kb)1 + $990,000/(1+(1+kb)2 + $20,000,000/(1+kb)2 kb= 10.77% Calculator Solution: n=2 PV=$18,000,000 PYMT= $990,000 FV=$20,000,000 Solve for 1 = 10.77%

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